A covered call is a popular options trading strategy that combines stock ownership with selling call options on the same stock. This approach is often used by investors who hold a long position in a stock and want to generate additional income through option premiums while potentially limiting their upside gains. It’s considered a relatively conservative strategy compared to buying naked call options or short selling.

How the Covered Call Works

In a covered call, you own shares of a stock and simultaneously sell a call option against those shares. The call option gives the buyer the right, but not the obligation, to purchase the stock from you at a predetermined price (known as the strike price) before or at the option’s expiration date. By selling the call, you collect the option premium upfront, which provides immediate income. However, if the stock price rises above the strike price, you might be obligated to sell your shares at that strike price, potentially capping your profits.

Formula:
Maximum Profit = (Strike Price – Purchase Price) × Number of Shares + Premium Received
Maximum Loss = Purchase Price × Number of Shares – Premium Received (assuming the stock price drops to zero)

Example:
Suppose you own 100 shares of Apple Inc. (AAPL), currently trading at $150 per share. You sell one call option contract (which usually covers 100 shares) with a strike price of $160, expiring in one month, and receive a premium of $3 per share ($300 total). Here’s what happens in a few scenarios:

1. If AAPL stays below $160 by expiration, the call option expires worthless, and you keep the $300 premium plus your shares. This income lowers your effective cost basis.

2. If AAPL rises above $160, say to $165, the call buyer exercises the option. You must sell your shares at $160, receiving a $10 per share gain plus the $3 premium. Although you miss out on additional gains above the strike price, your total profit is capped at $1,300 ([$160 – $150] × 100 + $300).

3. If AAPL falls below $150, you incur losses on the stock, partially offset by the $300 premium.

Common Misconceptions and Mistakes

One common misconception is that covered calls are risk-free since you own the underlying shares. While owning the stock does mitigate some risk compared to naked call writing, you are still exposed to downside risk if the stock price falls significantly. The premium received offers only limited protection.

Another mistake is setting the strike price too close to the current stock price (at-the-money). While this maximizes premium income, it increases the likelihood of having your shares called away, potentially forcing you to sell when you’d prefer to hold long-term. Conversely, setting the strike price too high reduces premium income and the strategy’s effectiveness.

Some traders also overlook transaction costs and tax implications. Frequent covered call writing can generate short-term capital gains from option premiums, which may be taxed at higher rates.

Related Queries

Investors often ask: “When is the best time to sell covered calls?” Generally, selling calls with 30 to 60 days to expiration balances time decay and premium income. Another common question is, “How does implied volatility affect covered call premiums?” Higher volatility increases option premiums, making covered calls more lucrative.

Conclusion

The covered call strategy is an effective way to enhance returns on stocks you already own by generating premium income. It works well in neutral to mildly bullish markets but requires vigilance regarding strike price selection and market conditions. Understanding the trade-offs—limited upside potential and ongoing downside risk—is key to using covered calls successfully.